The IRS’s three-year look-back policy, commonly known as the three-year rule, poses a significant challenge for those looking to transfer existing life insurance policies to an Irrevocable Life Insurance Trust (ILIT). Under this rule, if an insured individual transfers a policy to an ILIT and passes away within three years of the transfer, the entire policy proceeds are included in the insured’s gross estate. While establishing a trust with a new policy circumvents this issue, it may not always be feasible if there is an existing policy. We’ll explore the benefits of purchasing vs. gifting a policy into the trust.
AVOIDING THE 3-YEAR-RULE WITH A NEW POLICY
To avoid the three-year rule, the best practice is for the trustee to apply for a new life insurance policy to be issued and owned by the trust when it is opened. This ensures that the policy remains outside the insured’s estate, even if the grantor passes away within three years.
Once the trust is established, the grantor should initiate a transfer of cash to be used to pay the initial premium. The trustee should then apply for the new life insurance policy, with the trust as the original applicant and owner. It is imperative that the insured/grantor not have any possession of the policy at any time to avoid the lookback period. Upon the insured’s death, the proceeds are payable to the trust, providing liquidity for estate tax liabilities.
LEARN MORE: 5 ADVANTAGES OF ILITS FOR ESTATE PLANNING
OPTIONS FOR TRANSFERRING AN EXISTING POLICY: PURCHASING VS. GIFTING
However, situations may arise where transferring an existing policy becomes necessary. Common scenarios include policies purchased before estate taxation concerns arose, health changes preventing new coverage, or impending premium increases. In such cases, transferring the policy to an ILIT is advisable, albeit cautiously, due to potential estate taxation under IRC Sec. 2035. Options for transferring include gifting or selling the policy to the trust.
GIFTING A POLICY TO A TRUST
The insured/grantor can gift an existing life insurance policy into an ILIT to remove the death benefits from their taxable estate. They must give up all ownership and control over the policy to the trust. If the insured/grantor passes away within three years of gifting the policy to the trust, the policy proceeds will be subject to the three-year rule.
SELLING A POLICY TO A TRUST
The other strategy for moving an existing life insurance policy into an Irrevocable Life Insurance Trust is to remove the policy benefits from inclusion in the gross estate for the insured/grantor to sell it to the trust. This option avoids the three-year rule but comes with its own challenges. Before a sale can occur, a valuation and a purchase agreement must be drawn up, which should include details such as whether the purchase includes interest. Additionally, it can be challenging to ensure that the trust has the funds that it will need to purchase the existing life insurance policy and that those funds are held in the trust for the proper amount of time.
In conclusion, while obtaining a new policy for an ILIT is the preferred approach to avoid the three-year rule, circumstances may necessitate transferring existing policies. The best course of action depends on the specific needs and constraints of the grantor(s). To learn more about navigating the nuances of purchasing versus gifting policies to manage the three-year rule, watch the on-demand replay of our webinar “Quick Tips for Effective ILIT Management.” Our speakers Tony McKillip (President of LITCO), Amanda Einwechter (New Business Development Manager at LITCO), and Greg Kizer (Senior VP of ITM) will delve deeper into this topic alongside other commonly asked questions in trust management.
